If you default on your mortgage, it’s likely that you or the lender will eventually sell the property for less than you owe on it. And if your lender forgives the debt, it’s possible that you might have to pay income tax on the difference. The theory is that you are receiving a gift of this amount, because you don’t have to pay it back.
The IRS learns of the forgiven deficiency debt when it receives an IRS Form 1099C from the lender. This is a form on which a creditor reports income derived when repayment of a loan is no longer feasible—which would be the case in a short sale or foreclosure, or when the creditor writes off a debt.
Whether or not you’ll owe tax depends on the circumstances. Here are the basic rules.
Loans for your principal residence. If your default is on a mortgage or other debt secured by your house, and you used the money you borrowed to buy or improve your house, you won’t owe tax. (Before federal tax law changed in 2007, you might have had to pay income tax in this situation. This change in the tax law is set to expire on December 31, 2013.)
Loans for other real estate. If you default on a mortgage that’s secured by property that isn’t your primary residence, you’ll owe tax on any forgiven deficiency debt. So, for example, if you walk away from a loan on your second house in the country, expect a Form 1099 in the mail. The same is true for loans on non-residential real estate.
Loans not used for real estate. Similarly, if you take out a home equity loan and take that world trip you’ve been dreaming of instead of using the money to improve your house, you may end up on the wrong side of a tax bill.
EXAMPLE: Harry owes $200,000 on his second home, which is foreclosed on and sold at auction for $150,000. The lender files an IRS Form 1099, reporting the $50,000 difference as taxable income to Harry.
If you do face income tax liability, you have two possible ways of getting out from under it: the insolvency exclusion and bankruptcy. To use the insolvency exclusion, you’ll have to prove to the satisfaction of the IRS that your liabilities exceeded the value of your assets. Filing for bankruptcy works because debt wiped out (discharged) in bankruptcy has never been considered as taxable income. You’ll have to show that you filed for bankruptcy before the event that would cause the lender to file a Form 1099C. Of course, you’ll want to file for bankruptcy only if it otherwise makes sense.
You can fight back if an unpaid loan amount is treated as taxable income. If you receive a Form 1099 attributing income to you from mortgage debt forgiveness, but you think you shouldn’t owe the tax, file IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your regular tax return.
Will This Tax Break Last? Stay Tuned
The federal law (H.R. 3648) that makes people not liable for paying tax on the amount of a deficiency stemming from the sale of your residence is effective through 2013. This means that whatever happens to your home mortgage during that period will not increase your income tax as long as you meet the law’s qualifications. Whether Congress will extend the tax protection beyond 2013 is up in the air.